Staff Paper 12. Update on value chain analysis Introduction

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1 Staff Paper 12 Update on value chain analysis This staff paper has been produced by our office to assist stakeholders in responding to the Draft Determination. The material reflected in this staff paper has informed the preparation of the Commission s proposed conclusions. However, this staff paper does not form part of the Draft Determination. Accordingly, this staff paper should not be relied upon as expanding upon or replacing anything contained in the Draft Determination Introduction The proposed charge caps for Scottish are based on the costs of providing services at a retail level to households and at a wholesale level to licensed providers. The approach was based on a traditional vertically integrated view of a water and sewerage company, but with adjustments to charges to non-household customers to account for retail services (which for these customers are now competitive). However, these overall caps include activities that may be considered to be economically distinct. Underlying the charge caps is a value chain as illustrated in Figure Figure 12.1: Summary of Scottish s value chain Wholesale Retail resources and distribution networks Retailing water and sewerage services (household only) Sewage and discharge Sewage transporting networks 1

2 This paper outlines: recent developments in the water and sewerage industry that may impact on the way in which the water industry is regulated; the Commission s proposals to require Scottish to account separately for different parts of its network; the business areas that the Commission expects Scottish to account for separately; the information base that was used; the costs that were analysed in the Draft Determination; and indicative cost allocations for different parts of Scottish s network Recent developments While regulation of Scottish as a vertically-integrated company has served Scottish customers well to date, there are a number of reasons why it may be desirable to understand costs at a more detailed level in the future. These include: ensuring that economic regulation remains robust; the implications of the Albion Case; and the possible impacts of the Cave Review of water and sewerage competition and innovation in England and Wales. Economic regulation Analysis in this Strategic Review relies on econometric and unit cost models that compare Scottish s vertically-integrated costs with the costs of the water and sewerage companies in England and Wales. Adjustments are then made to account for differences caused by the separation of retail activities for non-household customers into a separate entity. This is possible because in the base year for this Review there remained a single retail operation in Scotland and the costs and service impacts of competition were yet to be realised. After this Review, however, the costs and service levels in Scotland may diverge from the costs and service levels observed in England and Wales, given the difference in the competitive framework. This will likely reduce the Commission s ability to rely on comparisons with the water and sewerage companies for benchmarking purposes. The Commission will consult with stakeholders on its proposed approach in advance of the next Strategic Review. However, it already considers that its approach is likely to involve understanding the costs of different activities that Scottish undertakes in order, possibly, to carry out a form of internal benchmarking. 2

3 Albion Case In a series of judgements over , the Competition Appeals Tribunal found that Dwr Cymru had abused its dominant position. It concluded that Dwr Cymru had conducted a margin squeeze by charging Albion an excessive price to access its water network in order to transport water. The Tribunal was notably critical of Dwr Cymru s ability to understand how its costs related to different activities and how these related to the price it proposed to Albion. In general, the Services etc. (Scotland) Act 2005 reduces the likelihood that some potential competition challenges to Scottish would be successful. The Act regulates access to Scottish s networks, allowing new entrants to provide retail services. It also creates an offence of introducing water to Scottish s networks, unless Ministers specifically provide for this to occur (by Order). It is, however, silent on the sale of treated water to Scottish. The Cave Review In April 2009, Professor Martin Cave published his report Independent Review of Competition and Innovation in Markets. It recommended that the water industry in England and Wales should adopt a model of retail competition like the one that has been introduced in Scotland. However, Professor Cave s Review went further than the current retail competition model in Scotland, promoting a phased approach to the introduction of upstream competition. This may include competition for water resources and competition for treated water. While Professor Cave s Review relates to competition in England and Wales, it raises some important issues that are relevant to Scotland Broad outline of the Commission s proposals The Commission intends to develop regulatory reporting requirements that separate Scottish s business units. The costs these businesses report (and therefore, notionally, the prices they charge one another) should reflect the full economic costs of supply, including all operating expenditure, depreciation and a cost of capital. The Commission has been advised that such an approach is more likely to be robust to future challenge under competition law. The degree of separation of the business units may evolve over time. For example, it may initially be appropriate for continuity to continue to require a single regulatory submission covering the full Scottish wholesale business. However, as understanding develops, the Commission may seek separate submissions from the different parts of the business. Having separated the units, it may then be appropriate to define how they should transact with one another. 1 Albion Limited & Albion Group Limited v Services Regulation Authority (Dŵr Cymru/Shotton Paper) Case 1046/2/4/04, [2006] CAT 23, [2006] CAT 36, [2008] CAT 31 and [2009] CAT 12. 3

4 By undertaking this process of accounting separation, the Commission is not trying to define how Scottish should run its business. That is properly a matter for the management of Scottish. However, the Commission has had legal advice to the effect that a failure to make progress in this area could expose Scottish to challenge under the Competition Act Business areas proposed for accounting separation In order to understand wholesale costs of supply, it is the intention to separate Scottish s costs of retail services to household customers. It should be possible to make quick progress in this area as there is already a degree of separation in the regulatory accounting information, the activities are reasonably well understood and the costs are significantly linked to the joint billing with council tax. Having separated household retail activities, the intention is to separate water and wastewater activities. Again, there should be quick progress in this area as many of the costs are already separated between water and wastewater and many of the assets used are different. Once water and wastewater costs have been separated, the Commission would like to separate these costs further into activities and network activities. As this approach may be different from the way in which the industry has considered its costs to date, the proposals are considered in more detail below. Network business units When referring to network businesses, this is taken to mean the underground network of pipes and sewers and other assets, such as pumping stations, that are used to transfer treated water to customers and transport wastewater from customers. The network will be required for the foreseeable future. As the Commission acts to ensure that its economic regulation of Scottish remains robust, it is mindful that in the long term it is likely that water and sewerage network businesses may continue to be characterised by natural monopoly. This may suggest that network businesses may need to bear the cost of ensuring that social obligations such as ensuring continuous supplies of water, draining rainwater or maintaining universal tariffs across Scotland are met. However, the network businesses are also likely to be characterised by a relatively stable business model. Their main function may be to maintain the networks of pipes and sewers in perpetuity. Any additions to the network are likely to be financed by those wishing to connect 2. The water industry has adopted a model of renewals accounting for infrastructure assets. Each year, water and sewerage companies estimate the long-run costs of 2 Save for reasonable cost contributions, which should, by definition, be self financing over a reasonable period. 4

5 maintaining infrastructure assets and charge this to their profit and loss account. In any individual year, the expenditure required may be different to this long-run charge and this may give rise to a financing requirement. However, over a long period the sum of annual charges and the sum of annual expenditure should be broadly equal. The RCV of Scottish, given the level of depreciation that has been allowed for in customers charges, is largely accounted for by the assets that have been built or improved to respond to the need for higher standards of public health and environmental compliance. These are primarily assets relating to water resources and and waste water and discharge. It is important that our understanding of the costs of a water and sewerage company, and the remuneration of the asset owner are, and are seen to be, consistent. For example, this understanding is critical to an assessment of the true economic and sustainable level of leakage. We would expect that the value of water and waste water assets would similarly dominate the current RCVs of the companies south of the border, especially given that the levels of compliance required are broadly similar. The natural monopoly nature of the network business suggests that robust benchmarking models will continue to be required. This may mean internal benchmarking of Scottish s costs of the business. The relatively stable and predictable nature of its business should make this benchmarking a realistic possibility. The Commission therefore intends to work with Scottish to develop and refine models that benchmark its network activities. This is likely to require a greater understanding of the drivers of costs and more detailed information than has existed to date. Our analysis suggests that the principal activity of water and sewerage companies is the management, design and delivery of water and sewage assets and their operation. And this is fully consistent with how the owners of water businesses earn their return: by investment in improving their asset based (principally in ) and not from their ownership of the legacy network. Treatment business units When referring to businesses, this is taken to mean slightly different functions on the water and wastewater sides of the business. On the water side, this refers to sourcing raw water; storing raw water in a reservoir; transferring raw water to a works; treating the raw water to appropriate standards and transferring the water into a service reservoir. On the wastewater side, it covers receiving sewage flows at a works; treating the waste water to an acceptable standard; discharging treated waste to the environment and disposing of any sludge. As outlined above, the Commission is keen to develop cost information that, if challenged, would not suggest that a margin squeeze was taking place. It therefore intends to develop reporting requirements that identify the full economic costs. This may mean understanding the different types of processes that Scottish undertakes. The Commission also intends to make more transparent the costs associated with developing new sources and providing varying levels of wastewater. 5

6 network separation Figure 12.2 sets out how the separation of a water business into a and a network business may operate 3. Figure 12.2: Example separation of water from water networks Develop water resources Extract raw water Resource assets Reservoirs Treatment business Raw or partially treated mains Transport raw water to works Treat raw water Treatment assets Any pipes or pumps that connect the above Support assets Transport treated water to service reservoir Store treated water in service reservoir Transport water through bulk mains (network storage) Transport water through local mains Network business Service reservoirs and water towers Bulk and local transportation mains Treated water pumping and booster stations Hydrants, valves and meters Support assets Figure 12.2 sets out a broad overview of the proposals. However, it is recognised that further detailed work will be required to refine the definition of assets, activities and costs that are allocated to each business unit. In particular, the Commission will wish to scrutinise closely the accounting boundary between and network activities Information base In order to provide transparency to stakeholders in relation to the Draft Determination, the Commission is publishing indicative cost allocations to the various business units. 3 The Commission s proposals for separating the wastewater networks into and distribution businesses are similar. 6

7 As part of its Business Plan submission, Scottish was asked to provide analysis of its value chain. Figure 12.3 outlines the wholesale business units that Scottish was asked to report on. For each of these units, Scottish provided the following categories of information: Annual costs of supply: operating expenditure, split by operating expenditure that can be directly attributed to an activity and operating expenditure that is apportioned to an activity; depreciation: split by current cost depreciation 4 and infrastructure renewals charge; an apportionment of interest and tax expenses. Assets used in supply: historic cost book value of assets; modern equivalent asset value of non-infrastructure assets (net and gross); modern equivalent asset value of infrastructure assets; working capital. While this information was beyond the level of detail that had previously been collected, Scottish was generally able to comply with the Commission s guidance and provide the requested information. The detailed commentary that Scottish provided made it possible to follow how Scottish had developed its information base and the assumptions it had made. The Commission requested information from Scottish about its network and costs for the base year of and forecast to The remainder of this section presents information from There is then a brief discussion about how this may change over time. 4 Scottish provided historic cost depreciation instead of current cost depreciation. 7

8 Figure 12.3: Outline of wholesale information reported by Scottish Resources Treatment Distribution Impounding reservoirs Large Small V small Lochs Rivers & burns Large Small V small Large Large Small Boreholes V small V small Bulk Storage Large V small Small Local Large V small Small Small Wastewater Reception and conveyencing Large Treatment V small Sludge Bulk Local Small - Business unit reported on by Scottish - Business unit where Scottish provided additional breakdown 8

9 12.6 Cost areas analysed Scottish s information was analysed and indicative costs allocated to four business units water, water networks, wastewater networks and wastewater. For each of the business units that were considered, the following were allocated: operating costs; maintenance costs; PPP charges; and cost of capital 5. Operating expenditure The information that Scottish provided on wholesale operating expenditure can be considered in two broad categories: Direct operating expenditure: that is, expenditure that is incurred and captured directly in relation to a specific activity. For example, Scottish may be able to record the electricity costs of a particular wastewater pumping station. Indirect operating expenditure (or overheads): that is, expenditure that does not relate to a specific activity but is necessary for Scottish to incur in order to provide its activities. For example, Scottish incurs costs relating to Human Resources that are not specific to a particular asset. These may be apportioned to a business activity by using, for example, headcount. Table 12.1 shows Scottish s reported operating expenditure in as direct and indirect expenditure. As can be seen, Scottish is able to report around two-thirds of its expenditure directly to an activity 6. 5 Specific corporation tax assumptions are not made as Scottish did not pay corporation tax in If PPP expenditure is included, this rises to around three-quarters. 9

10 Table 12.1: wholesale operating expenditure (excluding PPP) by category resources Detailed network area Direct operating expenditure Indirect operating expenditure Large 4m 2m Small 2m 2m Large 14m 7m Small 18m 11m Total operating expenditure Business area for indicative cost allocations 60m Treatment Bulk 7m 6m 65m Networks distribution Local 30m 23m total 75m 50m 125m Wastewater reception and conveyencing Bulk 9m 8m Local 22m 4m 42m Networks Large 6m 5m Wastewater Small 28m 12m 64m Treatment Sludge 11m 3m Wastewater total 75m 31m 107m Wastewater Overall total 150m 81m 232 Percentage of total 65% 35% 100% The indicative cost allocations use Scottish s apportionment of operating expenditure to individual activities (including its allocation of overheads). It is recognised that as the activity definitions and the boundaries between business units are refined, these costs may change. However, in this respect the Commission notes that Scottish is already able to allocate a high proportion of costs directly to activities, so movements of cost between different business units are likely to be around the margins. PPP charges Scottish incurs charges to PPP contractors for providing wastewater services. In these were around 125 million. In the indicative cost allocations, these charges are assumed to relate only to the business unit. It is unlikely that this allocation would change through time. 10

11 Maintenance costs In its current regulatory accounts, Scottish accounts for the costs of maintaining its assets using two distinct categories of charge: an infrastructure renewals charge : which is a notional long-run normative charge for maintaining assets currently classified as infrastructure; and a current cost depreciation charge : which is the cost of depreciating assets that are currently classified as non-infrastructure. Figure 12.4 sets out how these current industry accounting norms would be impacted by the separation of activities. Figure 12.4: Current maintenance charges Networks business units Treatment business units Current cost depreciation Pumping or storage assets in the water and wastewater business. and storage assets. Infrastructure renewals mains, drains and sewers. In wastewater business, there are minimal assets in this category. Examples include sea outfalls. In the water business, this includes raw water mains and assets associated with the offtake of water. It is the Commission s view that continuing to account for maintenance charges in the network business in two ways may not be appropriate. The network may be required to maintain its assets in perpetuity. It is therefore proposed to account for all assets in the network business using a network upkeep charge. This may operate in a similar manner to the current infrastructure renewals charge, but will include all assets in the network business. At this stage, it is not proposed to alter the accounting of maintenance in the business unit. The Commission would prefer to account for maintenance expenditure on noninfrastructure assets using current cost depreciation. However, in its value chain information return, Scottish did not provide current cost depreciation by area. The asset values that Scottish provides were used to estimate a current cost depreciation charge. However, there is a concern that this may be out of line with observed current cost depreciation charges in England and Wales 7. For the purposes of the indicative cost allocations, an average has been assumed of Scottish s reported historic cost and the estimated current cost depreciation charges. The overall assumptions on maintenance charges for the business units are set out in Table Staff Paper 3 contains a more detailed discussion of this issue. 11

12 Table 12.2: Maintenance charges by business unit networks Waste water network Waste water Total Network upkeep m charge 72m 57m Depreciation charge 91m 77m 168m Infrastructure renewals 10m charge 9m 1m Total 100m 72m 57m 78m 307m During the forthcoming regulatory control period, the Commission will work with Scottish to refine rules for calculating and allocating appropriate maintenance charges to different business units. Cost of capital For the indicative cost allocations, simplifying assumptions have been made on the cost of capital; the intention is to revise these over time. First a top-down estimate of the overall cost of capital for Scottish in was made; this was then apportioned to different parts of the network. Scottish s revenue in was assumed to be equal to costs 8. The 11% of household revenue that was assumed to relate to retail costs was removed from total revenue. This is consistent with the gross retail margin that was assessed for nonhousehold customers. This gave an overall level of wholesale costs of around 912 million in Next the sum of wholesale operating expenditure, depreciation and infrastructure renewals charges was deducted, to leave a value of the cost of capital of around 250 million. At this stage, a simplifying assumption was made that the return on capital is the same across each business unit. This is an assumption that the Commission will wish to revisit as the information improves. The cost of capital was apportioned to different network businesses by using simplifying assumptions about the level of capital requirement: for businesses, it was assumed that the capital requirement is around the net modern equivalent asset value; and 8 In a regulated business like Scottish, this should be a reasonable approximation, as regulatory reviews tend to make cost of capital assumptions that allow for an appropriate (but not excessive) level of profit. However, there may be variances in any one year caused by differences between the regulator s assumptions and actual company performance. 12

13 for network businesses, it was assumed that the capital requirement is around double the network upkeep charge (ie that a networks business may need to finance up to two years of network maintenance in advance). At this stage, no assumptions have been made about the need to finance working capital. Again, at a later stage, the Commission may wish to revisit this assumption and refine the information. The resulting cost of capital allocations are set out in Table Table 12.3: Cost of capital allocations ( ) networks Waste water network Waste water Total Cost of capital 143m 9m 7m 91m 250m The Commission plans to carry out more work in this area and will report its conclusions in the Final Determination Indicative cost allocations The indicative cost allocations are set out in Table Table 12.4: Indicative cost allocations for Waste water network Waste water network Total Operating expenditure 60m 64m 65m 42m 232m PPP charges - 124m m Maintenance charges 100m 78m 72m 57m 307m Cost of capital 143m 91m 9m 7m 250m Total 303m 357m 146m 106m 912m Percentage of total 33% 39% 16% 12% 100% Percentage of total (/networks) 72% 28% 100% The analysis was repeated for later years in this regulatory control period. This process showed that the proportionate allocation to the different parts of the network does not vary significantly from the information reported for

14 It is recognised that a number of assumptions have been made in generating the indicative cost allocations, not least in the allocation of the cost of capital to different parts of the network. The Commission intends to refine this information during the forthcoming regulatory control period and recognises that this may impose a cost on Scottish. The following has therefore been allowed for in the proposed charge caps: an additional 15 million (pre-efficiency) of capital expenditure that may be required to develop appropriate systems to capture the information; and 2.5 million of additional operating expenditure per year associated with capturing and reporting the information to us and the wider market place. The Commission believes that these allowances should be sufficient to allow for Scottish to develop significantly improved and detailed information. It is encouraged by Scottish s comments in its business plan about wishing to engage with the Commission in defining this new information Conclusion In the forthcoming regulatory control period, continuing to ensure that customers interests are promoted may require the Commission to understand Scottish s costs in greater detail than before. The Commission will consult with stakeholders as new methodologies and reporting requirements are developed. 14

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